QUANTA'S LEAP
Two competing Taiwanese companies take different views on moving to China.
By Abe De Ramos

Every day at three o'clock in the afternoon, an eerie silence falls upon the spotless workshop of Taiwanese laptop maker Quanta Computer. On all six floors of the factory located in Linkou, a Taipei suburb, workers, many of them women in their early 20s, take an obligatory quarter-hour nap, their heads laid next to the plastic casings of notebook PCs in various states of assembly. Lulling them to sleep is the soft drone and rhythmic click-clack of a sequence of machines - machines that eat motherboards at one end and produce the bare bones of computers at the other.

But even when the workers wake up, there is only the sound of rolling carts delivering hard disks and optical drives to break the silence. In fact, the halls of the once bustling factory are now sparsely populated. The action is now taking place in a shiny facility 420 miles away. Like many electronics companies that consider Taiwan home, Quanta has moved much of its production to mainland China. This year, the notebook PC maker - which serves customers from Dell to Apple to Sony - is expected to ship 70 percent, or 5.6 million notebooks, of its output from its Shanghai factory. Last year, the figure was just 25 percent.

To many CFOs, moving to China is an act of expediency, a conscientious effort to cut costs and raise profitability in an age of cutthroat competition and demanding shareholders. Likewise, to any business that wants to sell its goods to China's vast and expanding market, making these goods there is almost a no-brainer. As Sharon Su, an analyst at UBS in Taipei, says: "Over the long term, making a move to the mainland is not just an advantage; it's a must."

But to CFO Tim Li, the move to China represents something more meaningful: the evolution of Quanta. The company has been making notebook PCs for 15 years, earning its place as the leading laptop manufacturer in the world in terms of output, with sales this year expected to top US$7 billion. As the product becomes a commodity, margins are naturally shrinking. As such, Quanta is on a quest to develop post-PC products that would reverse the trend. "We're transferring the mature technology and products to mainland China," says Li, an industrial engineer who joined Quanta in 1989 initially as a design adviser to its chairman, Barry Lam.

"Our engineers there will just focus on upgrading existing technology and lowering the costs of existing products. In Taiwan, we have to design from zero to new product." In short, by moving laptop operations to China, Quanta is showing that it is graduating from a commodity industry, and marching into a new, untested territory. Its eyes are now set on high-end, low-volume corporate products such as storage and servers, as well as what it calls home gateways - futuristic set-top boxes that combine the functions of the television, computer, video player, game console, and remote control for all other home appliances.

"Every buyer knows that it is just a matter of time, maybe a couple of years, before computing, communications, and consumers will converge," Li says. "You cannot just survive on PCs."

Soon, the buzz at the Linkou factory will be supplanted by the noise that will come from the next building. Last spring, Quanta opened its NT$5 billion (US$140 million) research and development center. Currently, it only houses the 2,000 engineers that Quanta employs for itself and its TFT-LCD subsidiary, Quanta Displays. Within the next three years, the engineering population will be increased by 3,000, all working on the design and manufacture of new products. "The mainland is perfect in terms of cost, but technology-wise, they can't catch up," Li says. "They're still at elementary-school level; we are on master's degree level."

If Li sounds excited, he's probably counting potential margin gains in his head. The new direction "should offer better margins because of high-entry barriers, and huge outsourcing opportunities for those products," says UBS analyst Su, "but the question is how much it would account for in their combined revenues." Returns, too, are not likely to be instantly visible. "The direction is right, but the environment is not good," adds Tony Tseng, analyst at Merrill Lynch in Taipei. "Corporate spending on IT remains sluggish.".

Margin Erosion

Without a doubt, the notebook PC sector is still in its heyday. "The market is still growing very rapidly," says Frank Su, analyst at BNP Paribas in Taipei. According to technology research firm International Data Corp, globally shipments are expected to grow an average of 17 percent from this year to 2007, as more people ditch their desktops in favor of laptops. US investment bank Morgan Stanley estimates Quanta's sales this year will soar 83 percent, to a record NT$261 billion (US$7.6 billion), largely due to strong demand from US-based Hewlett-Packard (HP).

But to understand why Quanta is seeking a different path, it would help to look at its history and the competitive landscape. Lam founded the company in 1988, after resigning as president of Compal Electronics, then a contract manufacturer of computer monitors, while it was in the thick of a crisis after a fire broke out in its factory. To this day, Ray Chen, the incumbent president of Compal and Lam's former right-hand man, harbors resentment against this act of abandonment.

Lam concentrated on making Quanta the first Taiwanese company to focus on notebook computers, and it has since taken a leadership position in this field. It first started as an OEM, or original equipment manufacturer. As prices of components went down - think Moore's Law - the business of making products for foreign labels, designed by foreign labels, was becoming less and less profitable. To enhance its margins, Quanta invested in R&D to come up with its own notebook designs that it could sell and make for its clients. Currently, its engineers are able to generate 50 models a year, or four to five models a month.

As customers demanded just-in-time inventory management, Quanta enhanced its supply chain model to include the direct shipment of products ordered by its customers, say HP, to the products' end users, say an HP retailer. This model, however, has been replicated by Quanta's competitors, including Arima, Inventec, Wistron - and Compal, which has caught up to become the world's second largest laptop producer. "There is nothing that Quanta does now that its competitors aren't able to do," says Tony Tsai, an analyst at Taiwan Ratings, in Taipei. In fact, they all tend to produce for many of the same big-label clients.

The result is a natural erosion of margins. Gross margin from designing and manufacturing notebooks used to approach 20 percent, but in the last two years alone, Quanta has seen it decline, from 12.5 percent in 2001 to 8.8 percent last year. Morgan Stanley puts it at 7.1 percent for both 2003 and 2004. While Li admits that he is having difficulty keeping the margins up, he insists: "Of course I'll try to sustain it, but we prefer to focus on the net profit, instead of the margin."

Then again, that too, is in question. Since gross margin plays a huge role in profitability, Quanta's struggle in upholding it shows in its declining profit growth. Credit Suisse First Boston (CSFB) estimates its net profit to grow 22 percent this year to NT$13.2 billion (US$386 million), 20 percent in 2004 - and 4 percent in 2005. This is all the more stark given that its chief competitor, Compal, is doing well on both fronts.

Compal's gross margin was steady at 8.7 percent from 2001 to 2002, when the company won contracts, most notably from Apple Computer, at Quanta's expense. This year, this is even expected to grow to 9.5 percent, according to Lehman Brothers, one of the many research houses that consider Compal to have a better margin management strategy. Its net income, too, will sustain a healthy uptrend, growing 12 percent this year, 15 percent in 2004, and 14 percent in 2005, according to CSFB.

Investors have taken notice of the underdog. Once a second fiddle to Quanta, Compal shares are now high-flying. Year to date, share prices have risen 65 percent, compared to Quanta's 62 percent. "Between the two companies, we feel that over the past six quarters, Compal has managed to meet their guidance, in terms of margins and bottom line, and in most cases, even exceeded them," says Su of UBS. "Quanta, on the other hand, has in the past had a few more surprises, like last quarter when the margin was lower than expected." .

The China Factor

How Compal managed to sneak up on Quanta is a validation of the textbook logic of going to China. "We were able to generate high margins because we went to China sooner than our competitor," says Gary Lu, CFO of Compal. Until late 2000, Taiwanese notebook manufacturers were forbidden from producing in China. But since Compal started out as a producer of CRT monitors, its move to China began as early as 1997, says Lu. Because of this, the company was able to experience how to deal with bureaucracy, and more importantly, build relationships with suppliers.

By the time the ban was lifted, Compal was able to begin assembling its notebooks in China in no time - the first quarter of 2001. In contrast, Quanta only started its move to China early last year, and production started in July. This has two implications. First, Compal's gradual move to China was cost efficient. "Compal decided on an open system: if you want to be my supplier in China, you have to shift your production to China," says Tseng of Merrill Lynch. Lu claims to have spent a mere US$60 million since moving to China in 1997.

Quanta, on the other hand, had to literally bring its suppliers there. Of the 14 buildings constructed and under construction in its Shanghai Manufacturing City, several are earmarked for its suppliers - all of it at Quanta's cost - and are being rented out "at very little cost", says Li, who considers the arrangement as the price of good partnership. "How do you convince your suppliers to come with you?" he says. "You have to make sure that they have a profit too. Just because I get supplies from you, doesn't mean I should squeeze you."

Second, analysts attribute Compal's ability to win over clients from Quanta to its early move to China. Whatever the company saved on cost, part of those savings was "fed back to their customers," says Su of BNP Paribas, "and that's why they were able to grab market share in the notebook business, and prevent their margins from falling too fast." All this, Su adds, suggests that Compal "tends to react to the whole macro environment more rapidly than Quanta."

Li, however, disputes the disadvantage that some analysts see in Quanta's tardiness in China. To prove his point: the company was able to ramp up its production in China from 25 percent to 70 percent in a year, exceeding Compal's 60 percent. "Although Quanta was behind Compal in terms of moving to China, they have been ramping up their scale very fast, so it shouldn't be an issue any more," says Ellen Tseng, a Morgan Stanley analyst.

"Customers are not looking at your China production, but at your overall service - design capability, manufacturing capability, and logistics support," adds Tseng. Another reason this advantage is unlikely to last is that in the latter half of the year, Compal will begin to push up production for HP, which, after its acquisition of Compaq, has been known to squeeze its suppliers to save costs. "They can't improve their margins from now on," says Tseng of Merrill Lynch. "The only thing they can do is manage the margin trend or improve internal efficiency."

And Compal has not lost sight of this. Lu says Compal buffers its margin losses through product diversification. Though its core business is laptop design and manufacturing, it reaps handsome revenues from cell phones and Pocket PCs, which in turn generate gross margins of 14 to 18 percent, as opposed to notebooks' 6 to 8 percent. This trend is likely to continue, say analysts. Lu adds that in the next three years, only half of Compal's turnover would come from laptops. During that time, it would also shift up to 50 percent of its handheld and Pocket PC production to China.

Quanta, meanwhile, only began to expand its mobile phone business when it won contracts from Panasonic and Siemens this year. "Quanta was late for the mobile phone business, but it's kind of catching up," says Tseng.

On internal efficiency, Compal's materials management differs from Quanta's, and analysts support Lu's claim that it has enabled the former to have a better margin. Considering that materials account for more than 90 percent of total product cost - labor, China's main cost attraction, accounts for only 3 percent - this is a big advantage.

"Compal manages their component cost more efficiently than Quanta," says Tseng of Morgan Stanley. "Normally, components prices fluctuate, and if you can take advantage of the time lag, you can achieve better pricing overall." In short, Compal seizes the opportunity of buying more parts than it needs from suppliers when prices drop, whereas Quanta gets them as needed - a move that Tim Li says keeps inventory risk at bay."

Quanta Mechanics

Despite all of its advances, Compal, analysts agree, is not likely to catch up with Quanta in terms of revenues in the next three years simply because of the latter's scale. Compal this year is expected to ship about 5 million notebooks, 3 million short of Quanta. "Compal only exceeded Quanta's shipments for one month last year - and since then the gap has been widening," says Tseng of Merrill Lynch.

As such, Quanta's position as laptop king is nowhere threatened. And while its current margins are in question, its future direction - into servers, storage and home networking - though also questionable in present market conditions, increases its chances of continued dominance in the industry. "Quanta has a very clear vision compared with Compal, and you can see that in their investments in other businesses," says Su of BNP Paribas. "For Compal, I don't see that long-term goal for the group; it is still focusing on catching up with Quanta."

Asked about Compal's long-term strategy, CFO Lu says it is expanding into high-end consumer products as well. For example, it expects to be the first in Taiwan to ship out LCD televisions. "But even then, this business doesn't fall into one kind of concept, unlike Quanta, which has only one - home networking," says Su.

In the meantime, Li is consolidating the financial position of Quanta to enable it to pursue its future endeavors, at little cost to itself and its shareholders, through fiscal conservatism and inventory management.

Li takes offense at suggestions that Quanta has an inferior materials management strategy. In the first place, its sheer scale already allows it to buy components on the cheap. More importantly, you will not find more than a few days' worth of parts inventory in a Quanta warehouse - that is the point of keeping suppliers on call within the same complex. Inventory risk is off its balance sheet, but supplies are still literally just a stone's throw away.

Li works on the assumption that although prices fluctuate, they inevitably fall. "Don't forget that once you keep a lot of inventory, you keep a lot of risk," he says. "CPU (computer processors) prices always go down, and the customers will not share the loss with you." As such, he keeps a tight lid on materials purchases.

That doesn't make him popular with his sales and procurement teams. Internally, Quanta makes "very aggressive" business forecasts on a three-months rolling basis. Typically, CFOs will look at their cash-conversion cycle to analyze their cash flow, "but personally, I don't buy that story," he says. "I always think about the worst case scenario."

That means he assumes revenues will hit targets, but profits will not. "If sales say we'll have a 50 percent revenue increase, that means I will have to buy a lot of material - cash out," he says. "But if I assume I have no profits - no cash in - what will my cash flow template look like? How much would my cash gap be?" In effect, as CFO, Li acts as the brick wall to eager sales forecasts and procurement. The final decision falls on chairman Lam, whom Li meets every week with sales and procurement staff.

So far, it has worked. Although Quanta keeps inventories low, its good, solid relationship with suppliers means it hardly ever runs into a shortage. As such, it has a near-perfect record of order fulfilment. Currently, from the time a US-based customer gives an online order to HP, for example, it takes Quanta five days to fulfil it - two days to manufacture, two days to ship it, and one day of allowance. In Europe, the total is seven days, and in Asia, three.

In contrast, Compal suffered a backlash in the second quarter when Sars hit China and sales of mobile phones dropped, and the company had to deal with an inventory overhang. This is not to say that Li ignores market trends. Ultimately, his goal is to keep better track of his cash flow - making sure that the company has enough money for growth opportunities. For now, he is comfortable having a cash level - his "template" - equal to one month's revenues. "I have to prepare for our future growth, so I keep around one month of revenues," he says. For a company that is enjoying sequential revenue growth, that amount, currently US$700 million - is increasing.

To be sure, there is no reason for Li to be complacent. A subsidiary, Quanta Displays (QDI), will play an integral part in its future strategy, since QDI will supply the panels for its future products. Currently, QDI, a Quanta joint venture with Sharp of Japan, is still in the red. Asked how soon he expects it to turn a profit, Li gives a lengthy headshake. "Not in the next year," he says.

For now, his cash flow seems to be working well. Although Quanta raised funds from the Euro convertible market in June, it currently enjoys a net cash position. If this is sustained, then maybe, in the foreseeable future, Quanta will be able to move its post-PC products to China, and start cranking yet more next-generation ones in Taiwan.

Abe De Ramos is executive editor, Hong Kong, of CFO Asia.